Does Double-Dip Pass Duck Test?

If it looks like a duck, walks like a duck, and quacks like a duck, then chances are it is a duck. Regrettably, not everything passes the common “duck test” when it comes to judging the state of the economy. The prevailing opinion is the economy is on the brink of falling into another double-dip recession. Driving this sentiment has been the relentless focus on the softening short-term data (e.g., weekly jobless claims, monthly retail sales, daily dollar index, etc.). I’m no prophet or Nostradamus when it comes to picking the direction of the market, but if you consider the status of the steep Treasury yield curve, the perceived sitting duck economy may actually just be something completely different – perhaps one of those oily birds recovering from the BP oil spill.

Pictures Worth Thousands of Words

Despite all the talk of “double-dip”, the curve’s extreme slope is still near record levels achieved over the last quarter century. Here’s what the Treasury snapshot looks like now:

Graph source: The Financial Times

Does this look like an inverted yield curve, which ordinarily precedes an economy falling into recession? Quite the opposite – this picture looks more like a ramp from which Evel Knievel is about to jump. Maybe Federal Reserve Chairman Ben Bernanke is actually the daredevil himself by setting artificially low interest rates for extended periods of time? If so, it’s possible the economy will suffer a fate like Mr. Knievel’s at Caesar’s Palace, but my guess is we are closer to the take-off than landing based on the yield curve.

I’ve recently harped on the wide range of “double-dip” guesses made by economists and strategists (see “Probably” Wrong article), but if that was not enough for you, here are a few more cheery views taken from this weekend’s Barron’s magazine and a few other publications of choice:

Kopin Tan (Barron’s): “The Treasuries camp is expecting another recession… In reality, with retailers and customers alike eyeing a second recession this year, it’s a season of anxiety.”

John Crudele (NY Post): “We’ll get a correction that’ll put the words ‘double-dip’ back into the headlines… When the final figures are produced years from now, historians might just decide that this was just one long downturn — not a series of dips.”

Jeremy Cook (Chief Economist-World First): “This will further heighten fears that the US economy is careening into the dreaded double-dip recession.”

How can the double-dippers be wrong? For starters, as I alluded to earlier, we are nowhere near an inverted yield curve. The 10-Year Treasury Note currently yields 2.62% while the T-Bill a measly 0.15%, creating a spread of about +2.47% (a long distance from negative).

As this chart implies, and others confirm, over the last 50 years or so, the yield curve has turned negative (or near 0% in the late 1950s and early 1960s) before every recession. Admittedly, before the soft-patch in economic data-points, the steepness was even greater than now (closer to 3.5%). Maybe the double-dippers are just more prescient than history has been as a guide, but until we start flirting with sub-1% spreads, I’ll hold off on sweating bullets. Less talked about now is the possibility of stagflation (stagnant inflation). I’m not in that camp, but down the road I see this as a larger risk than the imminent double-dip scenario.

I’m not in the business of forecasting the economy, and history books are littered with economists that come and go in glory and humiliation. And although it’s fun guessing on what will or will not happen with the economy, I rather choose to follow the philosophy of the great Peter Lynch (see my profile of Lynch):

“Assume the market [economy] is going nowhere and invest accordingly.”

I choose to spend my time hunting and investing in opportunities all over the map. With fear and anxiety high, fortunately for me and my clients, I am finding more attractive prospects. While some get in the stale debate of stocks versus bonds, there are appealing openings across the whole capital structure, geographies, and the broad spectrum of asset classes. So, as others look to test whether the economic animal is a bear, bull, or duck, I’ll continue sniffing away for opportunities like a bloodhound.

*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in BP or any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

Good analysis, although John Hussman (actually Bill Hester)makes the point recently that yield curve slope doesn’t work so well as an indicator in deflationary (disinflationary?) environments. Any rebuttal to that specific point?

Thanks for the link. My chart only covers 50 years, so it doesn’t cover the Great Depression. I do not doubt the historical yield curve relationships were distorted 80 years ago – I just don’t believe we are in or heading in that direction.

The same goes for Japan. The U.S. spread between T-Bills and 10-Year is about 2.4% here vs. 0.8% currently in Japan. If we flatten to a level like Japan, then I think the arguments hold more water.

Certainly, if the economy tanks then deflation is a serious threat. My contention right now is the data doesn’t support that view yet.

I think the previous comment makes a good point. You are selectively choosing the data you use for comparison. Comparing the yeild curve to more relevant data points like the great depression would make more sense.

Your response to the above comment? Its probably true but I just don’t think that will happen. Great. Insightful.
Do you have anything else to back up your gut feelings other than inapproriate comparisons of the current yield curve?

“I’m not in the business of forecasting the economy”
Why are you attempting to do it then?